Since the whole idea of credit is based on paying off your debts as agreed, it’s no surprise that your payment history is the #1 factor used in calculating your FICO credit score. However, the other components of the FICO score are not well understood by many consumers. A category called “amounts owed,” which despite its name doesn’t place too much emphasis on the dollar amounts you owe, comes second in the formula. Instead, it focuses more on your debt-to-equity ratio, which is how much you owe relative to your available credit.
What is your debt ratio and why is it important?
Basically, your debt-to-equity ratio is a measure of how much you owe your creditors as a percentage of your available credit (credit limits). A low debt-to-equity ratio tells lenders that you’re using your credit responsibly, while a high debt-to-equity ratio could be a red flag that you might be overburdened.
For example, if you have a total credit limit of $10,000 and credit card debt of $2,000, your debt-to-credit ratio is 20%. Meanwhile, if your friend has $50,000 of available credit and owes $5,000, his debt ratio is 10%. So even if your friend has 150% more credit card debt than you, that person might look better to lenders (and the credit scoring model).
It’s also important to note that the “amounts owing” category isn’t just limited to your debt-to-equity ratio. Other things include how many of your accounts have balances, specific account balances, and how much you owe on loan accounts (such as mortgages and car loans) compared to original balances .
The specific formula used to calculate your FICO score is a closely guarded secret, but maintaining a good debt-to-equity ratio is an effective way to increase this category’s contribution to your credit score.
How much is too much?
There are no official rules telling us what constitutes a “high” debt-to-credit ratio, and the impact of a high debt-to-credit ratio depends on your specific credit situation. In other words, maxing out credit cards can affect your credit score and the credit scores of your friends in different ways. That said, there are some helpful guidelines that anyone can follow.
The majority of personal finance writers (myself included) recommend using no more than 30% of your available credit at any given time to avoid a negative effect on your credit score. In addition, the formula also examines individual accounts. So even if you’re only using 15% of your available credit, but have one credit card maxed out, that could be a bigger negative factor than if the balance was spread across multiple accounts. For this reason, I would expand the usual recommendation to include keeping your debt ratio below 30% on all of your individual credit cards.
The lower your debt ratio, the better off you’ll be – up to a point. FICO “high performers” – those consumers with scores above 800 – use on average only 7% of their available credit. In addition, FICO officials called credit usage of less than 10% “great shape.” However, the company also warned that something is better than nothing when it comes to credit card debt, at least as far as FICO ratings go. In other words, having a balance of a few dollars on a credit card to demonstrate how you are using your credit responsibly may be better for your score than having no balance at all.
To sum up, the ideal debt ratio seems to be between 1% and 10%, but anything below 30% is considered a good use of your available credit.
The take-out sale
A low debt-to-equity ratio is an important part of maintaining a strong credit rating. Although there is no set rule, the basic idea is to keep yours as low as possible. Not only will a low ratio help boost your credit score, but you’ll also save a lot of money on credit card interest by not carrying high balances. Paying off your credit card debt is a win-win situation and should be a priority for anyone serious about improving their financial health.